Volatility Regimes

Published: 2017-07-31

Finance theory and practice indicate that we should pay attention to the volatility of a financial asset. While it is good to pay attention to volatility it is necessary to be aware that the volatility of an asset can change radically. The Thai Baht provides an illustration of this phenonmenon.

Very Low, Very High, Moderate

The Thai Baht / US Dollar exchange rate appears to have gone through three volatility regimes since the beginning of 1981:

Very Low: Until 1997-July-02 the Baht was pegged to the US Dollar (see Wikipedia).
Very High: During the Asian Currency Crisis, which began in Thailand, the peg to the US Dollar was abandoned and the exchange rate shot up, exhibiting extreme volatility. It is interesting to note that right before it shot up the Baht shot down a bit, probably due to an attempt by the Thai Central Bank to defend the currency.
Moderate: Since the Asian currency crisis the Baht floats freely against the Dollar and the exchange rate exhibits moderate volatility.

The abrupt shift from very low to very high volatility in 1997 is an example of the principle put forth by Hegel that "everything conceals its opposite". Apparent serenity can conceal massive risk. This was also seen in the Western economic system, which shifted abruptly from the "Great Moderation" to the Financial Crisis of 2007-2009 and its aftermath. The Financial Crisis did not have much of an adverse effect on the Asian economies; evidently they had learned the lessons of 1997-8 and installed effective buffers.

Price changes

Speaking of everything concealing its opposite: Below are plotted percentage price changes from one trading day to the next. The graph shows that when the Baht was pegged to the dollar the exchange rate experienced a number of large shocks.

Evidently it is not easy to peg a currency. More generally, an apparently placid price series can exhibit signs of strain when viewed under a graphical microscope.

Now that the Baht floats freely against the dollar, large shocks appear to be completely absent.

Fear very low volatility

One inference that might be drawn from the above is that moderate volatility may be safer than very low volatility. When things are very smooth it may be because adverse forces are being repressed. Investors love very low volatility; perhaps they should learn to fear it as much as they do very high volatility.